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"Foreign Exchange and Risk Management": (In Partial Fulfillment of Award of MBA Degree)
"Foreign Exchange and Risk Management": (In Partial Fulfillment of Award of MBA Degree)
FOREIGN EXCHANGE
And
RISK MANAGEMENT
(In partial fulfillment of award of MBA degree)
INTRODUCTION
Authorized dealers they are one who can undertake all types of
foreign exchange transaction. Bank are only the authorized
dealers. The only exceptions are Thomas cook, western union,
UAE exchange which though, and not a bank is an AD.
Even among the banks RBI has categorized them as followes:
Branch A They are the branches that have nostro and vostro
account.
Branch B The branch that can deal in all other transaction but
do not maintain nostro and vostro a/cs fall under this category.
4. EXCHANGE BROKERS
forex brokers play very important role in the foreign exchange
market. However the extent to which services of foreign brokers are
utilized depends on the tradition and practice prevailing at a particular
forex market center. In India as per FEDAI guideline the Ads are free
to deal directly among themselves without going through brokers. The
brokers are not among to allowed to deal in their own account allover
the world and also in India.
5. OVERSEAS FOREX MARKET
Today the daily global turnover is estimated to be more than US
$ 1.5 trillion a day. The international trade however constitutes hardly
5 to 7 % of this total turnover. The rest of trading in world forex
market is constituted of financial transaction and speculation. As we
know that the forex market is 24-hour market, the day begins with
Tokyo and thereafter Singapore opens, thereafter India, followed by
Bahrain, Frankfurt, paris, London, new york, Sydney, and back to
Tokyo.
6. SPECULATORS
The speculators are the major players in the forex market.
Bank dealing are the major pseculators in the forex
market with a view to make profit on account of favorable
movement in exchange rate, take position i.e. if they feel
that rate of particular currency is likely to go up in short
term. They buy that currency and sell it as soon as they
are able to make quick profit.
Corporations particularly multinational corporation and
transnational corporation having business operation
beyond their national frontiers and on account of their
cash flows being large and in multi currencies get in to
foreign exchange exposures. With a view to make
advantage of exchange rate movement in their favor they
either delay covering exposures or do not cover until cash
flow materialize.
Individual like share dealing also undertake the activity of
buying and selling of foreign exchange for booking short
term profits. They also buy foreign currency stocks, bonds
Exchange rate
System
FUNDAMENTALS IN
EXCHANGE RATE
DIRECT
VARIABLE UNIT
HOME CURRENCY
INDIRECT
VARIABLE UNIT
FOREIGN CURRENCY
2) In direct method:
Home currency is kept constant and foreign currency is kept
variable. Here the strategy used by bank is to buy high and sell low.
In India with effect from august 2, 1993,all the exchange rates are
quoted in direct method.
It is customary in foreign exchange market to always quote two
rates means one for buying and another rate for selling. This helps
in eliminating the risk of being given bad rates i.e. if a party comes
to know what the other party intends to do i.e. buy or sell, the
former can take the letter for a ride.
There are two parties in an exchange deal of currencies. To initiate
the deal one party asks for quote from another party and other
party quotes a rate. The party asking for a quote is known as
asking party and the party giving a quotes is known as quoting
party.
The advantage of twoway quote is as under
i.
ii.
iii.
iv.
v.
`
In two way quotes the first rate is the rate for buying and another for
selling. We should understand here that, in India the banks, which are
authorized dealer, always quote rates. So the rates quoted- buying and
selling is for banks point of view only. It means that if exporters want
to sell the dollars then the bank will buy the dollars from him so while
calculation the first rate will be used which is buying rate, as the bank
is buying the dollars from exporter. The same case will happen
inversely with importer as he will buy dollars from the bank and bank
will sell dollars to importer.
FACTOR AFFECTINGN EXCHANGE RATES
In free market, it is the demand and supply of the currency
which should determine the exchange rates but demand and
supply is the dependent on many factors, which are ultimately
the cause of the exchange rate fluctuation, some times wild.
The volatility of exchange rates cannot be traced to the single
reason and consequently, it becomes difficult to precisely define
the factors that affect exchange rates. However, the more
important among them are as follows:
STRENGTH OF ECONOMY
POLITICAL FACTOR
Fiscal policy
Interest rates
Monetary policy
Balance of payment
Exchange control
Central bank intervention
Speculation
Technical factors
Hedging tools
Introduction
Consider a hypothetical situation in which ABC trading co. has to
import a raw material for manufacturing goods. But this raw material
is required only after three months. However, in three months the
price of raw material may go up or go down due to foreign exchange
fluctuations and at this point of time it can not be predicted whether
the price would go up or come down. Thus he is exposed to risks with
fluctuations in forex rate. If he buys the goods in advance then he will
incur heavy interest and storage charges. However, the availability of
derivatives solves the problem of importer. He can buy currency
derivatives. Now any loss due to rise in raw material price would be
offset by profits on the futures contract and viceversa. Hence, the
derivatives are the hedging tools that are available to companies to
cover the foreign exchange exposure faced by them.
Definition of Derivatives
Derivatives are financial contracts of predetermined fixed duration,
whose values are derived from the value of an underlying primary
financial instrument, commodity or index, such as : interest rate,
exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to
reduce exposure to changes in foreign exchange rates, interest rates,
or stock indexes or commonly known as risk hedging. Hedging is the
most important aspect of derivatives and also its basic economic
purpose. There has to be counter party to hedgers and they are
speculators.
Derivatives have come into existence because of the prevalence of risk
in every business. This risk could be physical, operating, investment
and credit risk.
1. Forward Contracts
Forward exchange contract is a firm and binding contract, entered
into by the bank and its customers, for purchase of specified amount
of foreign currency at an agreed rate of exchange for delivery and
payment at a future date or period agreed upon at the time of entering
into forward deal.
The bank on its part will cover itself either in the interbank market
or by matching a contract to sell with a contract to buy. The contract
between customer and bank is essentially written agreement and bank
generally stand to make a loss if the customer defaults in fulfilling his
commitment to sell foreign currency.
A foreing exchange forward contract is a contract under which the
bank agrees to sell or buy a fixed amount of currency to or from the
company on an agreed future date in exchange for a fixed amount of
another currency. No money is exchanged until the future date.
A company will usually enter into forward contract when it knows
there will be a need to buy or sell for an currency on a certain date in
the future. It may believe that todays forward rate will prove to be
more favourable than the spot rate prevailing on that future date.
Alternatively, the company may just want to eliminate the uncertainity
associated with foreign exchange rate movements.
The forward contract commits both parties to carrying out the
exchange of currencies at the agreed rate, irrespective of whatever
happens to the exchange rate.
The rate quoted for a forward contract is not an estimate of what
the exchange rate will be on the agreed future date. It reflects the
interest rate differential between the two currencies involved. The
forward rate may be higher or lower than the market exchange rate on
the day the contract is entered into.
Forward rate has two components.
Spot rate
Forward points
Forward points, also called as forward differentials, reflects the
interest differential between the pair of currencies provided capital
flow are freely allowed. This is not true in case of US $ / rupee rate as
there is exchange control regulations prohibiting free movement of
capital from / into India. In case of US $ / rupee it is pure demand
and supply which determines forward differential.
Forward rates are quoted by indicating spot rate and premium /
discount.
In direct rate,
Forward rate = spot rate + premium / - discount.
Example :
The inter bank rate for 31st March is 48.70.
Premium for forwards are as follows.
Month
Paise
April
May
June
40/42
65/67
87/88
48.70 + 0.42
48.70 + 0.67
48.87 + 0.88
For 17th May the premium would be (0.67 0.42) * 17/31 = 0.137
Therefore the premium up to 17th May would be 48.70 + 0.807 =
49.507.
Premium when a currency is costlier in future (forward) as compared
to spot, the currency is said to be at premium vis--vis another
currency.
Discount when a currency is cheaper in future (forward) as compared
to spot, the currency is said to be at discount vis--vis another
currency.
Example :
A company needs DEM 235000 in six months time.
Market parameters :
Spot rate IEP/DEM 2.3500
Six months Forward Rate IEP/DEM 2.3300
Solutions available :
The company can do nothing and hope that the rate in six
months time will be more favorable than the current six months
rate. This would be a successful strategy if in six months time
the rate is higher than 2.33. However, if in six months time the
rate is lower than 2.33, the company will have to loose money.
It can avoid the risk of rates being lower in the future by
entering into a forward contract now to buy DEM 235000 for
delivery in six months time at an IEP/DEM rate of 2.33.
It can decide on some combinations of the above.
Introduction
Consider a hypothetical situation in which ABC trading has to
import a raw material for manufacturing goods. But this raw material
is required only after 3 months. However in 3 month the prices of raw
material may go up or down due to foreign exchange fluctuation and
at this point of time it cannot be predicated whether the prices would
go up or down. Thus he is exposed to risks with fluctuation in forex
rates. If he buys the goods in advance then he will incur heavy interest
and storage charges. However, the availability of derivatives solves the
problem of importer. He can buy currency derivatives. Now any loss
due to rise in raw material prices would be offset by profit on the
futures contract and vice versa. Hence the derivative are the hedging
tools that are available to the companies to cover the foreign exchange
exposures faced by them.
Derivatives defined
Derivatives are financial contracts of pre-determined fixed
duration, whose values are derived from the value of an underlying
primary financial instrument, commodity or index, such as: interest
rates, exchange rates, commodities, and equities.
Derivatives are risk-shifting instrument. Initially, they were
used to reduce exposure to change in foreign exchange rates, interest
1. FORWARD CONTRACTS
Forward exchange contract is a firm and binding contract, entered
into by the bank and its customers, for purchase of specified amount
of foreign currency at an agreed upon at the time of entering into
forward deal.
The bank on its part will cover itself either in the inter- bank market
or by matching a contract to sell with buy. The contract between
customers and bank is essentially written agreement and bank
generally stands to make a loss if the customer default in fulfilling his
commitment to sell foreign currency.
A foreign exchange forward contract is a contract under which the
bank agrees to sell or buy a fixed amount of currency to or from the
company on an agreed future date in exchange for a fixed amount
currency. No money is exchanged until that future date.
A company will usually enter into forward contract when it knows
there will be a need to buy or sell foreign currency on a certain date in
the future. It may believe that todays forward rate will prove to be
more favorable than the spot rate prevailing on that future date.
Alternatively, the company may just want to eliminate the uncertainty
associated with foreign exchange rate movements.
Paise
40/42
65/67
87/88
Example :
Lets take the same example for a broken date forward contract spot
rate = 48.70 for 31st March.
Premium for forwards are as follows
30th April
31st May
30th June
48.70 + .42
48.70 + .67
48.70 + .88
For 17th May the premium would be (.67 - .42) * 17/31 = .137
Therefore the premium up to 17th May would be .67 + .137 =.807
Therefore the forward rate for 17th May would be 48.70 + .807 =
49.507.
Premium when a currency is costlier in future (forward) as compared
to spot, the currency is said to be at premium vis--vis another
currency.
Discount when a currency is cheaper in future (forward) as compared
to spot, the currency is said to be at discount vis--vis another
currency.
Example :
A company needs DEM 235000 in six months time.
Market Parameters :
Spot rate IEP/DEM = 2.3500
Six months forward rate IEP/DEM = 2.3300.
Solution available :
The company can do nothing and hope that the rate in six
months time will be more favorable than the current six
months forward rate. This would be successful strategy if in a
six months time the rate is higher than 2.33. However, if in a
six months time the rate is lower than 2.33, the company will
have to lose money.
It can avoid the risk of a rates being a lower in the future by
entering into a forward contract now to buy DEM 235000, for
delivery in six months time at an IEP/DEM at rate of 2.33.
It can decide on some combinations of the above.
Various options available in forward contracts :
A forward contract once booked can be cancelled, rolled over, extended
and even early delivery can be made.
Roll over forward contracts
Rollover forward contracts are one where forward exchange contract is
initially booked for the total amount of loan etc. to be re-paid. As and
when installment falls due, the same is paid by the customer at the
exchange rate fixed in forward exchange contract. The balance amount
of the contract rolled over till the date for the next installment. The
process of extension continues till the loan amount has been re-paid.
But the extension is available subject to the cost being paid by the
customer. Thus, under the mechanism of roll over contracts, the
exchange rate protection is provided for the entire period of the
contract and the customer has to bear the roll over charges. The cost
of extension (rollover) is dependent upon the forward differentials
prevailing on the date of extension. Thus, the customer effectively
protects himself against the adverse spot exchange rates but he takes
a risk on the forward differentials. (i.e. premium/discount). Although
spot exchange rates and forward differentials are prone to fluctuations,
yet the spot exchange rates being more volatile the customer gets the
protection against the adverse movements of the exchange rates.
A corporate can book with the Authorised Dealer a forward cover on
roll-over basis as necessitated by the maturity dates of the underlying
transactions, market conditions and the need to reduce the cost to the
customer.
Example :
3.)
Exchange difference not exceeding Rs. 100 is being ignored by
the contracting Bank.
4.)
In the absence of any instructions from the client, the contracts,
which have matured, shall be automatically cancelled on 15 th day falls
on a Saturday or holiday, the contract shall be cancelled on the next
succeeding working day.
In case of cancellation of the contract
1.)
Swap, cost if any shall be paid by the client under advice to him.
2.)
When the contract is cancelled after the due date, the client is
not entitled to the exchange difference, if any in his favor, since the
contract is cancelled on account of his default. He shall however, be
liable to pay the exchange difference, against him.
Early Delivery
Suppose an Exporter receives an Export order worth USD 500000 on
30/06/2000 and expects shipment of goods to take place on
30/09/2000. On 30/06/200 he sells USD 500000 value 30/09/2000 to
cover his FX exposure.
Due to certain developments, internal or external, the exporter now is
in a position to ship the goods on 30/08/2000. He agrees this change
with his foreign importer and documents it. The problem arises with
the Bank as the exporter has already obtained cover for 30/09/2000.
He now has to amend the contract with the bank, whereby he would
give early delivery of USD 500000 to the bank for value 30/08/2000.
i.e. the new date of shipment.
However, when he sold USD value 30/09/2000, the bank did the same
in the market, to cover its own risk. But because of early delivery by
the customer, the bank is left with a long mismatch of funds
30/08/2000 against 30/09/2000, i.e. + USD 500000 value 30/08/2000
(customer deal amended) against the deal the bank did in the inter
bank market to cover its original risk USD value 30/09/2000 to cover
this mismatch the bank would make use of an FX swap.
The swap will be
1.)
2.)
value (customer deal amended) against the deal the bank did in the
inter bank market to cover its original risk + USD 500000
To cover this mismatch the vank would make use of an FX swap, which
will be ;
1. Buy USD value 30/08/2000.
2. Sell USD value 30/09/2000.
The swap necessitated because of early delivery may have a swap cost
or a swap difference that will have to be charged / paid by the
customer. The decision of early delivery should be taken as soon as it
becomes known, failing which an FX risk is created. This means that
the resultant swap can be spot versus forward (where early delivery
cover is left till the very end) or forward versus forward. There is every
likelihood that the origial cover ratre will be quite different from the
maket rates when early delivery is requested. The difference in rates
will create a cash outlay for the bank. The interest cost or gain on the
cost outlay will be charged / paid to the customer.
Substitution of Orders
The substitution of forward contracts is allowed. In case shipment
under a particular import or export order in respect of which forward
cover has been booked does not take place, the corporate can be
permitted to substitute another order under the same forward
contract, provided that the proof of the genuineness of the transaction
is given.
Advantages of using forward contracts :
They are useful for budgeting, as the rate at which the company
will buy or sell is fixed in advance.
There is no up-front premium to pay whn using forward
contracts.
The contract can be drawn up so that the exchange takes place
on any agreed working day.
Disadvantages of forward contracts :
They are legally binding agreements that must be honoured
regardless of the exchange rate prevailing on the actual forward
contract date.
2. OPTIONS
An option is a Contractual agreement that gives the option buyer
the right, but not the obligation, to purchase (in the case of a call
option) or to sell (in the case of put option) a specified instrument at a
specified price at any time of the option buyers choosing by or before
a fixed date in the future. Upon exercise of the right by the option
holder, and option seller is obliged to deliver the specified instrument
at a specified price.
Put Options
Call Options
PUT OPTIONS
The buyer (holder) has the right, but not an obligation, to sell
the underlying asset to the seller (writer) of the option.
CALL OPTIONS
The buyer (holder) has the right, but not the obligation to buy
the underlying asset from the seller (writer) of the option.
STRIKE PRICE
Strike price is the price at which calls & puts are to be exercised
(or walked away from)
AMERICAN & EUROPEAN OPTIONS
American Options
The buyer has the right (but no obligation) to exercise the
option at any time between purchase of the option and its maturity.
European Options
The buyer has the right (but no obligations) to exercise the
option at maturity only.
UNDERLYING ASSETS :
Physical commodities, agriculture products like wheat, plus
metal, oil.
Currencies.
Stock (Equities)
INTRINSIC VALUE :
It is the value or the amount by which the contract is in the option.
When the strike price is better than the spot price from the buyers
perspective.
Example :
If the strike price is USD 5 and the spot price is USD 4 then the buyer
of put option has intrinsic value. By the exercising the option, the
buyer of the option, can sell the underlying asset at USD 5 whereas in
the spot market the same can be sold for USD 4.
The buyers intrinsic value is USD 1 for every unit for which he has a
right to sell under the option contract.
IN, OUT, AT THE MONEY :
Calls
in-the-money
at-the-money
out-of-the-money
Puts
out-of-the-money
at-the-money
in-the-money
Naked Options :
A naked option is where the option position stands alone, it is
not used in the conjunction with cash marked position in the
underlying asset, or another potion position.
Pay-off for a naked long call :
A long call, i.e. the purchaser of a call (option), is an option to
buy the underlying asset at the strike price. This is a strategy to take
advantage of any increase in the price of the underlying asset.
Example :
Current spot price of the underlying asset : 100
Strike price : 100
Premium paid by the buyer of the call : 5
(Scenario-1)
If the spot price at maturity is below the strike price, the option will
not be exercised (since buying in the spot is more advantageous).
Buyer will lose the premium paid.
(Scenario-2)
If the spot price is equal to strike price (on maturity), there is no
reason to exercise the option. Buyer loses the premium paid.
(Scenario-3)
If the spot price is higher than the strike price at the time of maturity,
the buyer stands to gain in exercising the option. The buyer can buy
the underlying asset at strike price and sell the same at current
market price thereby make profit.
However, it may be noted that if on maturity the spot price is less than
the INR 43.52 (inclusive of the premium) the buyer will stand to loose.
CURRENCY OPTIONS
A currency option is a contract that gives the holder the right (but not
the obligation) to buy or sell a fixed amount of a currency at a given
rate on or before a certain date. The agreed exchange rate is known as
the strike rate or exercise rate.
An option is usually purchased for an up front payment known as a
premium. The option then gives the company the flexibility to buy or
sell at the rate agreed in the contract, or to buy or sell at market rates
if they are more favorable, i.e. not to exercise the option.
How are Currency Options are different from Forward
Contracts ?
A Forward Contract is a legal commitment to buy or sell a fixed
amount of a currency at a fixed rate on a given future date.
A Currency Option, on the other hand, offers protection against
unfavorable changes in exchange raters without sacrificing the
chance of benefiting from more favorable rates.
Types of Options :
lets assume that the option premium quoted is 0.98 % of the USD
amount (in this case USD 1000000). This cost amounts to USD 9800
or IEP 6125.
Outcomes :
If, in one months time, the exchange rate is 1.5000, the cost of
buying USD 1000000 is IEP 666,667. However, the company
can exercise its Call Option and buy USD 1000000 at 1.6000.
So, the company will only have to pay IEP 625000 to buy the
USD 1000000 and saves IEP 41667 over the cost of buying
dollars at the prevailing rate. Taking the cost of the potion
premium into account, the overall net saving for the company
is IEP 35542.
On the other hand, if the exchange rate in one months time is
1.7000. The company can choose not to exercise the Call
Option and can buy USD 1000000 at the prevailing rate of
1.7000. The company pays IEP 588235 for USD 1000000 and
saves IEP 36765 over the cost of forward cover at 1.6000. The
company has a net saving of IEP 30640 after taking the cost of
the option premium into account.
In a world of changing and unpredictable exchange rates, the
payment of a premium can be justified by the flexibility that
options provide.